Feldstein-Horioka puzzle
Encyclopedia
The Feldstein-Horioka puzzle is a widely-discussed problem in macroeconomics
and international finance
, first documented by Martin Feldstein
and Charles Horioka
in an 1980 paper. According to economic theory, if we assume that investors that are able to easily invest anywhere in the world, they invest in countries that offer the highest return per unit of investment. Which would drive up the price until the return per unit of investment across different countries is similar. If we believe this is true then statistical data would show no relationship between savings and investment within a single country. However, the data gives evidence of the exact opposite.
The discussion stems from the economic theory that capital flows act to equalize marginal product of capital across nations. In other words, money will flow from lower to higher marginal products until the increased investment lowers the return to the level of the rest of the world. Under this model, a saver in France will have no incentive investing in the French economy, but rather would invest in the economy with the highest productivity return to his capital (the highest marginal productivity of capital). Therefore, increased saving rates within one country need not result in increased investment.
FH argued that if there is perfect capital (K) mobility, we should observe low correlation between domestic investment (I) and savings (S). Investors in one country do not need the funds from domestic savers and can borrow from international markets at world rates. By the same token, savers can lend to foreign investor the entirety of the domestic savings. According to standard economic theory, in the absence of regulation in international financial markets, the savings of any country would flow to countries with the most productive investment opportunities. Therefore, domestic saving rates would be uncorrelated with domestic investment rates. This is the same fundamental insight which underlies several other results in economics like the Fisher separation theorem
.
If the capital flows between OECD countries are reasonably free, this should hold true for domestic saving and investment rates for those countries. Feldstein and Horioka observed that, for OECD countries, domestic savings rates and domestic investment rates are, instead, highly correlated, in contrast to standard economic theory.
Maurice Obstfeld
and Kenneth Rogoff
identify this as one of the six major puzzles in international economics. The others are the home bias in trade puzzle
, the equity home bias puzzle
, the consumption correlations puzzle
, the purchasing power and exchange rate disconnect puzzle, and the Baxter-Stockman neutrality of exchange rate regime puzzle.
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...
and international finance
International finance
International finance is the branch of economics that studies the dynamics of exchange rates, foreign investment, global financial system, and how these affect international trade. It also studies international projects, international investments and capital flows, and trade deficits. It includes...
, first documented by Martin Feldstein
Martin Feldstein
Martin Stuart "Marty" Feldstein is an economist. He is currently the George F. Baker Professor of Economics at Harvard University, and the president emeritus of the National Bureau of Economic Research . He served as President and Chief Executive Officer of the NBER from 1978 through 2008...
and Charles Horioka
Charles Horioka
Charles Yuji Horioka is an American economist residing in Japan. Horioka received his B.A. and Ph.D. degrees from Harvard University and is currently professor of economics at the Institute of Social and Economic Research at Osaka University...
in an 1980 paper. According to economic theory, if we assume that investors that are able to easily invest anywhere in the world, they invest in countries that offer the highest return per unit of investment. Which would drive up the price until the return per unit of investment across different countries is similar. If we believe this is true then statistical data would show no relationship between savings and investment within a single country. However, the data gives evidence of the exact opposite.
The discussion stems from the economic theory that capital flows act to equalize marginal product of capital across nations. In other words, money will flow from lower to higher marginal products until the increased investment lowers the return to the level of the rest of the world. Under this model, a saver in France will have no incentive investing in the French economy, but rather would invest in the economy with the highest productivity return to his capital (the highest marginal productivity of capital). Therefore, increased saving rates within one country need not result in increased investment.
FH argued that if there is perfect capital (K) mobility, we should observe low correlation between domestic investment (I) and savings (S). Investors in one country do not need the funds from domestic savers and can borrow from international markets at world rates. By the same token, savers can lend to foreign investor the entirety of the domestic savings. According to standard economic theory, in the absence of regulation in international financial markets, the savings of any country would flow to countries with the most productive investment opportunities. Therefore, domestic saving rates would be uncorrelated with domestic investment rates. This is the same fundamental insight which underlies several other results in economics like the Fisher separation theorem
Fisher separation theorem
In economics, the Fisher separation theorem asserts that the objective of a corporation will be the maximization of its present value, regardless of the preferences of its shareholders. The theorem therefore separates management's "productive opportunities" from the entrepreneur's "market...
.
If the capital flows between OECD countries are reasonably free, this should hold true for domestic saving and investment rates for those countries. Feldstein and Horioka observed that, for OECD countries, domestic savings rates and domestic investment rates are, instead, highly correlated, in contrast to standard economic theory.
Maurice Obstfeld
Maurice Obstfeld
Maurice Moses "Maury" Obstfeld is a professor of economics at the University of California, Berkeley.He is well known for his work in international economics. He is among the most influential economists in the world according to IDEAS/RePEc....
and Kenneth Rogoff
Kenneth Rogoff
Kenneth Saul "Ken" Rogoff is currently the Thomas D. Cabot Professor of Public Policy and Professor of Economics at Harvard University. He is also a chess Grandmaster.-Early life:...
identify this as one of the six major puzzles in international economics. The others are the home bias in trade puzzle
Home bias in trade puzzle
The Home bias in trade puzzle is a widely-discussed problem in macroeconomics and international finance, first documented by John T. McCallum in an article from 1995....
, the equity home bias puzzle
Equity home bias puzzle
The Equity home bias puzzle is the term given to describe the fact that individuals and institutions in most countries hold only modest amounts of foreign equity. This is puzzling since observed returns on national equity portfolios suggest substantial benefits from international diversification...
, the consumption correlations puzzle
Backus-Kehoe-Kydland puzzle
In economics, the Backus–Kehoe–Kydland consumption correlation puzzle, also known as the BKK puzzle, is the observation that consumption is much less correlated across countries than output.In an Arrow–Debreu economy, i.e...
, the purchasing power and exchange rate disconnect puzzle, and the Baxter-Stockman neutrality of exchange rate regime puzzle.